Chapter ObjectivesI. The Market for CurrenciesA. Foreign Exchange Rate—the price of any one country’s currency in terms of another country’s currencyCHAPTER 7THE INTERNATIONAL MONETARY SYSTEM AND FINANCIALMARKETSChapter Objectives- To understand how currencies are traded and quoted on world financial markets- To examine the links between interest rates and exchange rates- To understand the similarities and differences between domestic sources of capital and internationalsources of capital- To examine how the needs of individual borrowers have changed the nature of the instruments traded onworld financial markets in the past decade- To understand how the debt crises of the 1980s and 1990s are linked to the international financialmarkets and exchange ratesOpening VignetteAsian Currencies and the Fear of FloatingSummary:This vignette tells how the trade deficit of the United States is mainly with Asia. Asian countries continue to peg their currency to the dollar and are more concerned about rising unemployment that the value of their currencies. Most likely they will continue to peg their currencies to the dollar to keep trade and employment high.Chapter OutlineI. THE MARKET FOR CURRENCIESA. FOREIGN EXCHANGE RATE—THE PRICE OF ANY ONE COUNTRY’S CURRENCY IN TERMS OF ANOTHER COUNTRY’S CURRENCYB. Exchange Rate Quotations and Terminology1. Direct quotation—when the subject ($) currency is stated first ($1.1478/€)2. Indirect quotation—when the subject (€) currency is stated second ($1.1478/€)3. Spot rate—rate for the exchange of currencies for immediate transaction (2 business days)4. Forward rate—a contract that provide for two parties to exchange currencies on a future date at an agreed-upon exchange rate (30,90,120,180, and 360 days)C. Direct and Indirect Quotations1. European terms—quoting a currency in direct quotes versus the U.S. dollar2. American terms—quoting a currency as U.S. dollars per pound serling or per Australian dollarD. Cross Rates—quoting the exchange rate of a currency without using the U.S. dollar as a reference (¥136.46/€)E. Percentage Change CalculationsF. Foreign Currency Market Structure1. Informal—no central location2. Uses telecommunications and is always openG. Market Size and CompositionX 100 = -16.67%¥125/$ - ¥150/$ ¥150/$1. Growth has been astronomical due to---a. Deregulation of International Capital Flowsb. Gains in Technology and Transaction Cost Efficiencyc. The World is a Risky Place2. Centered in London, New York and TokyoFocus On e-BusinessOnline Global Currency ExchangeSummary:This vignette tells about Currenex, Inc. that was stared in 1999 to provide an open online global currency exchange. It links institutional buyers and sellers worldwideFocus On CultureThe Linguistics of Currency TradingSummary:This vignette provides an imaginary conversation to give insight into the jargon used in currency trading.II. Purpose of Exchange Rates—for tradeA. What is a Currency Worth?1. Theory of Purchasing Power Parity (PPP)—should equalize purchasing power (Pricein Japan = Exchange rate X Price in U.S.)B. The Law of One Price—purchasing power parity that estimates the exchange rate between two currencies using just one good or service as a measure of the proper exchange for all goods and servicesIII. Monetary Systems of the Twentieth CenturyA. The Gold Standard1. Fixed exchange rates between participating countries2. Money had to be back by gold reserves3. Gold would act as an automatic adjustment flowing between countriesB. The Interwar Years, 1919-1939—due to the depression countries became isolationist and trade dwindledC. Ther Bretton Woods Agreement, 1944-19711. Fixed exchange rates based on an “adjustable peg”2. Establishment of IMF as a fund of gold and currencies to stabilize member countries asneeded3. Establishment of World Bank to provide funding for long-term development projects4. Convertibility was in terms of the U.S. dollarD. Times of Crisis, 1971-19731. U.S. went off the gold standard in 1971 and fixed exchange rates ended2. World currency trading nearly ground to a halt by 1973E. Floating Exchange Rates, 1973-Present1. Direct intervention helped countries maintain a desired value of currency by their buying or selling their own currency2. Soon countries had to resort to altering economic variables such as interest rates to alter motivations and expectations3. Coordinated intervention developed by the Plaza Agreement set goals and policies of the Group of Five (G5) nations of France, Japan, West Germany, U.S. and U.K.IV. The European Monetary System and the EuroA. European Community formed the European Monetary System establishing a grid of fixed parity rates among member currenciesB. The Maastricht Treaty (1991) specified a timetable for adoption of a single currencyC. The Euro—launched on January 1, 19991. “Why” Monetary Unification—to facilitate free flow of people, goods, services and capital2. Fiscal Policy and Monetary Policy—monetary policy conducted by European Central Bank (ECB)3. Fixing the Value of the Euroa. Fixed value to the 11 participating EU countries’ currencies when startedb. Allowed to float in world marketsV. International Money MarketsA. Eurocurrency is any foreign currency-denominated deposit or account at a financial institution outside the country of the currency’s issuance (such as the Eurodollar)B. Eurocurrency Interest Rates are without restrictions1. Interbank interest rates are charged by banks to banksC. Linking Eurocurrency Interest Rates and Exchange Rates1. Eurocurrency interest rates are the basis for quoting forward ratesVI. International Capital MarketsA. Defining International Financing1. Category 1: Domestic Borrower/Domestic Currency2. Category 2: Foreign Borrower/Domestic Currency3. Category 3: Domestic Borrower/Foreign Currency4. Category 4: Foreign Borrower/foreign CurrencyVII. International Banking and Bank LendingA. Structure of International Banking1. Correspondent bank is not owned by a domestic bank, but is used for foreign bankingoperations2. Representative bank is a sales office for a bank3. Branch bank, banking affiliated, or wholly owned banking subsidiaryVIII. International Security MarketsA. The International Bond Market—same 4 categories as for International FinancingB. International Equity Markets are becoming more popularFocus On CultureEquity Market Crises in the Twentieth CenturySummary:This